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Sunday, April 18, 2010

See you in court

The best reporting on the SEC charges against Goldman that I've found so far is by Felix Salmon at Reuters. See the post I linked to and several more he's made in the past day or two.

I still think the SEC will have a tough time with this case. In terms of public opinion (no nuance), this is definitely a black eye for Goldman. But a court of law is a different thing, one hopes.

Below are two comments from Felix's blog that sum up the issue nicely. ABN/IKB are the large European banks that were big buyers of the senior tranches of the Abacus deal in question (more correctly, ABN was an insurer of the Abacus risk). ACA is the Abacus CDO manager that collected millions of dollars in fees and put its reputation on the line. The records show that they rejected many of Paulson's suggestions for reference names to be placed in the structure.

The bottom line is that when a trade occurs the buyer and seller typically have different views on the likely future of the security. See my previous post for some color on what the world looked like when the Abacus deal was being done. If ABN/IKB had done well with their investment they might be chuckling today: "Yeah, we took a lot of money from those short chumps back in 2007. Can you believe we got 100 bps for free for AAA! Who is John Paulson?"

Somehow it's easier to blame this disaster on evil fraudsters than on plain stupidity.

Well, that’s all very nice, but what is it that ACA was supposed to have done for the fee it was paid? Just accept Paulson’s selections? Were they not supposed to be you know actually evaluating the structure and underlying assets?

When a firm gets millions of dollars to validate an investment, doesn’t it have some obligation to do some research?

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I'm still at a loss to understand why sellers of credit protection would have changed their mind if they knew the buyer of the protection structured the transaction.

Do ABN/IKB assume all market participants are lazy and gullible as they are? Popeye the Sailor could have selected the collateral but it was incumbent on ABN and IKB to perform their own due diligence on the underlying assets.

Paulson/GS also had no inside or non-public information that these bonds would default. They structured the CDO based on their view that the bonds were likely to default. This information was also available to ACA, ABN, IKB.

Paulson/GS certainly didn’t force the homeowners to default on their payments or cause the bond trustee to declare the bonds in default.

If I sell you a share of Apple stock, chances are I am less optimistic than you are about the future price. However, it's also possible I'm selling it just for risk management or asset allocation reasons; maybe I have too much concentration in my portfolio so I'm selling it just to rebalance. But we usually don't require that the buyer has to know my reasons for selling the share. The SEC is more or less saying Goldman committed fraud by not letting the buyers know that Paulson really thought subprime was a bubble, and wasn't simply hedging his mortgage positions. Yes, Paulson suggested names for the structure, but ACA was there to vet all of them.

The WSJ has a nice analysis of ACA's role, and its centrality to the case, here.

This NYTimes article describes the internal dynamics at Goldman -- until very late there was no consensus that CDOs built from subprime assets would melt down.

26 comments:

If Paulson "selects" 100 and ACA "vets" them and uses only 50 of Paulson's selections, then Paulson "selected" the portfolio and ACA only "vetted" them. Paulson played the most significant role in detemrining the portfolio constituents.

If you were conducting a drug trial and the pharmaceutical company presented you a pool of candidates for the trial from which you choose the participants, that would merit disclosure, don't you think?

It's not a scientific expt. Caveat emptor. The entity whose credibility is on the line is ACA - look at the pitch docs; they are sellng their expertise. If they felt all of P's picks were bad they could have refused them - but they wanted the fee. How is that GS's fault?

"Somehow it's easier to blame this disaster on evil fraudsters than on plain stupidity."

Steve, You ask the question as if it's without context, when there's a context. That's the function of "somehow" and "easier" in your sentence. It's like asking the question "Why can't it be stupidity instead of fraud?", as if it's a question of physical or logical possibility. The question only makes sense in context. In this case, the context of Fabrice " fabulous Fab" Tourre. The context will involve an analysis of expertise, reputation, self-promotion, etc.

Let me give an example. My ad firm places an advert for a product. The case put forward is clear, concise, and easy to understand. On the other hand, the necessary disclaimer is long, tedious, and hard to understand. Now, you might say "Why can't it be verbosity? Or poor writing?" Fine. However, if it turns out that I wrote both of these parts of the ad, you will be aware that I can write very effectively. So, you might well conclude that I was deliberately being obtuse in the disclaimer. Whether that's legal or not is one question, while whether I'm somebody you want to hire or do business with is another. That will depend upon what you value in doing business,

The deal, called Abacus 2007-AC1, was created by Goldman after Paulson & Co. asked the bank to facilitate a large bet the fund wanted to make against the housing market by creating a structure called a collateralized debt obligation, or CDO, that the Paulson firm could bet against.

And Goldman got some asshat company to bless it and then sold it to investors.

What more needs to be said? It's a fucking swindle. The sad thing is that regulatory system is so owned by these grifters that the legality of such a swindle is debatable. What a messed up sleazy racket!

Well, P Y, the "asshat company" that blessed it was the main investor in the deal, and they were an expert in these securities - something that Paulson probably wasn't. We can potentially change the regulatory system, but beware how much of a nanny state you wish to create. Taken to the absurd extreme, someday you may find yourself locked in a box because the govt views the entire world as too dangerous for you to handle, so you can enjoy the safety of a padded cell. If your view is that ACA was just an asshat company when it came to mortages securities, exactly what decisions do you think any of us are personally qualified to make? More than one person has commented that the only thing making ACA look bad is the Monday morning quarterbacking that they lost money. Remember, before this deal blew up, ACA had rights - and they certainly viewed doing this deal as well within their right.

I'm still at a loss to understand why sellers of credit protection would have changed their mind if they knew the buyer of the protection structured the transaction.

The problem is not that the buyer of the protection structured the assets. It's that the "protection" wasn't protection. ACA "insured" Goldman, not Paulson. But Goldman had no insurable interest in the CDO, which creates intolerable moral hazard for anyone with an ounce of insurance sense. Goldman issued its own CDS to Paulson, which gave Goldman a reason to want insurance from ACA, but that's really a form of reinsurance, not a true insurable interest, and a sane reinsurer examines the underlying risk before issuing insurance. Had ACA done that, it would have discovered that Paulson was shorting the pool he had created, and they would clearly have walked away from insuring the pool (and, if the timing allowed, they would have walked away from the whole deal with Paulson as structurer). Paulson was a smart guy. If he liked a mortgage, that would give ACA more confidence in its own assessment; if he disliked a mortgage, that would give ACA less confidence. Insurance people take such things into account, because they deal in risk, not certainty, and the opinion of an expert is a datum they are allowed to consider and will consider.

ACA was every stupid. It's easy to steal from fools, but their being fools does not make stealing from them something else.

It is easy here, and possibly unfair, to call ACA "stupid" after the fact. Was there anything in ACA's and/or Paulson's concept of which particular mortgages to include that made Paulson money or cost ACA money? If either had hedged their position against a randomly selected portfolio, I suspect they would be looking at breakeven. 99% of the portfolio got downgraded because 99% of subprime mortgages across the market were downgraded.

...the "asshat company" that blessed it was the main investor in the deal, and they were an expert in these securities

What's expertise in this industry? The ability to lie through ones teeth to some unfortunate slob trying to make a quick buck for sitting on their ass and letting their 'money work for them'?

Taken to the absurd extreme, someday you may find yourself locked in a box because the govt views the entire world as too dangerous for you to handle, so you can enjoy the safety of a padded cell.

Taken to the extreme indeed. No water and you die of thirst. Too much and you drown. We must get rid of the water!!! What is the logical fallacy on display here? Whenever I hear a financial type espousing libertarianism I check my pocket to make sure my wallets still there!

Anyway, LY, you're so steeped in the sleaze that you're missing the most important point: Goldman knowingly sold junk to suckers. The asshat company was brought in simply to give the illusion of wholesomeness. It was a swindle.

Do you financial types have to undergo some surgical procedure that removes our inborn aversion to doublethink? Are MBA programs just two years of pretend academics followed by the big brain procedure?

[ACA] were an expert in these securities - something that Paulson probably wasn't.

Given that Paulson is the one that made money off this deal, this doesn't speak well for the value-add of expert analysis in these matters.

True, this could be a case of the gambler getting lucky and winning against the house at craps. But given that the systemic failure of these kinds of financial instruments it seems more likely that the experts don't know how these deals should be structured and priced any more than some random idiot from off the street. Or in a blog comment section for that matter.

Therefore, perhaps it is within our rights as citizens to revue what the experts did, and decide if they should be allowed unfettered freedom to do the same thing all over again. Given that they wrecekd the world economy and created the biggest financial crisis in almost 80 years, perhaps a few restrictions going forward are warranted. Calling that nanny statism is either asinine, stupid, or self-serving. The government bailing everyone* out after they fell down and skinned their knees looks a hell of a lot more like nanny-statism than do new regulations not allowing the "experts" to keep on doing the same stupid stuff that got us into this mess.

* By "everyone" I of course mean the financial bigshots, minus the guys at Lehman. The rest of us remain well and truly fucked.

You need to keep in mind that the review process and the writing of new regulations will not be made by "citizens" in general. Government "experts" will be the ones charged with analysing what the other "experts" have done, writing new regulations and applying them.

I'm not saying you can't trust government "experts" over private sector ones but, obviously, the ability to make great mistakes is not a private sector monopoly. And I fear that "the greater the power, the more dangerous the abuse".

Mariano, I agree with anything you wrote. And most of the proposals I have read seem like they wouldn't have done anything to prevent events from recent years - it's just the politicians pretending to do something because they feel they have to.

Nevertheless, as much as I feel the need to keep a wary eye on government, we also need to keep another wary eye on corporations, especially the financial corps. Big Business can be abusive, too, though usually in different ways. And government is better suited to checking the power of Big Business than any other insitution. Personally I believe in a well-regulated economy. That means the regs should be 'good', and there should be the right amount of them - not too few, and certainly not too many. Forget Solomon, we need Goldilocks in charge.

Icepick - the only thing you say that I disagree with is that mortgage finance by Wall St wrecked the economy. Western budget deficits, trade deficits, an ageing population, and loose monetary policy (as described in the Keynes and Hayek rap on youtube) have led to overconsumption in the West that was inevitably gonna lead to a moderation. Americans can't own 6000 sq ft homes and three S.U.V.'s for very long. Ultimately Wall St is sound, it is only GM, Fannie and Freddie that will put the taxpayer out of pocket. I like Goldilocks too. But regulate carefully please - as Mariano says, bad decisions are not a private sector monopoly.

Who benefited most from that over consumption? Wall Street firms. Who encouraged the policies that led to over consumption? Wall Street and the financial arms of the government, which rotate the players from one sector to another. It would feel less like a giant rip-off if the people on Wall Street were getting hit as hard as the rest of the economy. Don't bother telling me the MBS guys are all out of work now. Did they give back their bonuses? Did their bosses lose their jobs and the bonuses they reaped? Did the regulators take a hit? Has anyone at the SEC, in the FRBs or any of the other regulatory agencies been fired for their incompetence? At least some of those guys got promoted (see Geithner) and stand to make millions more when they rotate over to the private sector. Regulatory capture is a beautiful thing.

Lets see those guys lose damned near everything they've got, and then maybe I'll be willing to cut them some slack.

[I]t is only GM, Fannie and Freddie that will put the taxpayer out of pocket.

Only if you ignore the wreckage around the rest of the economy. Surely that ought to count for something.

But even ignoring that, do you really believe that AIG and the FHA aren't going to cost the tax payers a bundle? And frankly it's hard to believe that the banks are in good shape. Beyond the TARP we've also seen the Fed take $1.25 trillion in MBS off the market and exceptionally low interest rates essentially giving the banks an advantage that no one else gets. And we'll still probably see around three hundred or more banks fail during this cycle. That's if the underlying economy gets better soon, which is dependent on consumption going up. (Unlikely with U-6 over 17% and real wages declining steadily.) What will the banks do as the CRE losses start rolling in? And all of that ignores the suspension of FASB accounting rules that make the banks look much more sound than they are.

Well, I think that three things dominate the present and future - globalization, globalization and globalization. Looking at Joe Random on Wall St - he's not waited on by a household staff and riding horses about his estate. He's living in a 1700 sq ft Manhattan apmt. The quality of his car is a little nicer, but not a lot nicer on the scale of things. He eats out a lot, but he works long hours. He has marketable skills which will command a good wage anywhere in the world. At the moment, the winners in the U.S. are the broad middle class. People who can't integrate ln(x), and many of whom think the world was created 6000 yrs ago - but make 30 times Chinese workers with superior skills and work ethic. They are living way over their global equilibrium. If you look at income percentiles across societies, I don't think the wealthier Americans are the primary beneficiaries of the current regime, compared to all other global regimes.

On the second part, the wreckage, I am tempted to argue that Washington created the agencies and that they played the dominant role in the crisis - not banks - but that has been debated on this blog before.

As for the Fed and that $1 trio of MBS, I refer again to the Keynes and Hayek rap. Cheap credit is the hair of the dog and Washington is addicted. If we deflate life will get hard for the banks, but a government $10 trio in debt with an unsolved structural $1 trio deficit is not gonna deflate. Notice the price of gold?

I think you are too pessimistic Icepick. When I was a kid we waited 4 hours in line to buy 2 gallons of gasoline so that my dad could go to work the next day - and I am not that old. Since the 1970's we've built an incredibly wealthy society for the middle class. I hope we don't screw it up, and I admit that under-regulation seems as threatending to me as over-regulation.

One caveat on the pessimism - as you say, U-6 is bad - and I don't know what we are gonna do about it because I don't expect it to improve. The lower middle class is in trouble and we need a solution and I don't know what it will be.

If you believe Steve's analysis of East Asian IQ, surely the average Wall St dude is in a lot more trouble in the longer term than middle America, as at his IQ level he is relatively more outnumbered (plus he's in an industry that is very mobile). Ok he may have cashed out by then!

Regarding the MBS - are you really saying that the removal $1 trillion of them from the banks books hasn't helped them return to profitability? That seems kind of an absurd thing to say.

LY, I'm forty-two and I remember the gas lines. Big deal. I also remember that we didn't have millions and millions of (financially) underwater homes, and had much lower levels of debt. A lot of the prosperity has been taken on loan from future years. Now it's time to pay up.

As for how great it is to be middle class now - bullshit. I've been out of work two years. True, that's just one data point. But I've got friends in the same boat, and I only need to go out one or two layers (friend of a friend) before I know a LOT of people in similar circumstances. Most of us are educated, with at least half knowing (or at least having once knew) calculus. That doesn't seem to have helped. If no one is hiring, it doesn't matter if I know integral calculus, functional analysis, stochastic theory, or even any group/ring/ideal theory. (Incidentally, I got fired in early 2008 for being the only financial analyst at my Fortune 50 company to claim a recession was coming. Most of those that claimed GDP would be 6% or higher in 2008 - 2012 are still working. So much for justice. But hey, at least I can integrate ln(x)!) I find the claims that college grads have an unemployment rate below 5% right now to be laughable. Admittedly, this is just my small section of the country, but when I talk to friends and relatives elsewhere I keep hearing the same story. Everybody is squeezed, and everyone knows several people who have been out of work for a long time. The only people I hear talk about how good the times are work for the federal government.

The people I know that are holding on to jobs are at best in a holding pattern. One friend has now won the "Employee of the Year" honor two years running. The reward he has received is no pay increase for those two years. You may recall that first place used to mean a new Caddy. Now it means you're not fired. Hell, he didn't even get the effing steak knives!

The "broad middle class" is getting a little slimmer every day. So it's really difficult to believe that things are just fine right now from a structural stand point.

Icepick - again I think you make good points all. BUT - do you think 1970's regulation would make you better off? Would Smoot Hawley like tarriffs make you better off? I am NOT sanguine. But stringing up a bunch of bankers and blaming them for a problem a generation in the making, and due to forces well beyond them, ain't gonna solve my problems or yours. However, I do think our politicians can help us improve the economy - if we "reform" and don't just tag govt power grabs as reform.I wanna be like Ricky Roma, I suspect I am like Williamson, but I fear I am really like Lingk.

Geronimo - On buying MBS - since virtually all banks hold MBS as "hold to maturity", only real losses on the part of the Fed end up helping them. I don't think the fed is taking losses on the trio MBS book, so far ...

On IQ - ah, this blog an IQ - I think IQ is a big part of success, but alone IQ isn't enough. But, despite high East Asian IQ, Steve also bemoans brain drain into finance, so maybe the Wall St dudes are OK for a bit - but I agree that in the long run numbers will win out if culture adapts.

I'm not aware that I've called for regulations from the 1970s. Times change, the regulations & laws need to change too. So far the only change in the laws, though, seems to have been removing old ones from the books and adding useless new ones. (See Glass-Steagal & Sarbanes-Oxley, respectively.)

It appears that the biggest problem in recent years is that the regulators didn't want to do their jobs, I will assume for a variety of reasons. Every week seems to bring up another case of an analyst at a regulatory agency identifying a problem only to have their superiors quash any follow-up. Some reasons for this appear to be: Political pressure from on high, complacency, regulatory capture, and simple incompetence. I have no idea how to regulate against those Four Horsemen, and I doubt anyone else does either.

As for stringing up a bunch of bankers - I'm not yet entirely dedicated to the pitch forks and torches idea, but I get a little closer every day. It would be nice to know that they're suffering for their mistakes, and I'm just not seeing it. You may fear big government power grabs. Others fear big business. Personally I fear corporate government, where the biggest corporations have captured the government for their own benefit. So GE netted almost $11 billion in profits last year, but managed to pay no taxes. GE also stands to benefit from the new health care legislation. And GE's chairman happens to be very close to Obama. Where's Arsenio Hall when you need him?

(Admittedly, Arsenio Hall is very rarely needed. And believe me, I am NOT claiming the Republicans are any different.)

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As for Smoot-Hawley, maybe protectrionism isn't the way to go. But it is hard to argue that globilization has been pure free trade, either. Every nation hasn't turned into Singapore. The playing field is not level, be it farm subsuidies in the US (and pretty much everywhere else), anti-GM food regs by the Europeans, the Chinese pegging their currency to ours or the lax environmental regs in the Third World. (That last has let us export our pollution, which was a nice secondary effect.) But it might be nice of our elites took some interest in anything other than their profits. If so they might have had considered some other long term consequences of their actions.

Icepick - much thanks - and you didn't call me an MBA unlike someone else here ( and that really hurt!). I call a corporate/state entity fascism, and that's why I am so bugged by GM and the agencies. I am not a fan of conspiracy theories, but it bugs me the US govt is finding a buncha problems with Toyota now that it operate GM. And I agree our response to globalization if non-obvious, but the choices we make will be critical ...

The point I was trying to make re: IQ is that if you believe the East Asian IQ orthodoxy, it is more the Wall St guys who are earning above their global equilibrium point, contrary to your assertion. Personally, while I don't completely buy the IQ story (that was more of a lead in) - I certainly believe that financial workers in the West are not currently experiencing the same level of competition from globalisation as in many other parts of the economy. This is pretty obvious to me anecdotally - from my classmates similarly qualified people earn vast multiples more money in financial services than they do in other parts of the economy. Why that is, I'm not 100% sure, but I suspect it is just a transient effect that will only persist until Asian financial institutions become competitive globally with their Western counterparts.Wall St is just making hay while the sun shines. Or something :)

On a similar theme, it seems to me that the ultimate beneficiaries of globalisation are not smart people, they are people that already own stuff in rich parts of the world. I could go on and on about that...

Re: the MBS, yes ok - but the Fed taking on all that debt has helped keep interest rates low and led to a lot fewer defaults than there would otherwise have been. The Fed took the nukes and defused as many as it could. Otherwise they would be blowing up in the banks faces. Or do I have that wrong?

Geronimo - I think it is a blend of IQ/culture/"what you already own" that matters in globalization. These three factors for most Americans are weak, as most as, dare I say: below Asian IQ, lazy, and in debt. Something is propping them up, and I think the finance industry is no small part. However, I am not convinced that Asians will come to dominate the globe anymore than Europeans came to dominate sub-sarahan Africa.

On the Fed and rates - if you think low interest rates create free money, I invite you to go long any short term interest rate instrument and see if it works for you. There is zero barrier to entry.